ECON 575

FUNDAMENTALS OF ECONOMICS

CHAPTER 6
PRODUCTION

Prof. Dr. Dilek TEMİZ DİNÇ

In our discussions of consumer choice during the preceding chapters, an
existing menu of goods and services was taken for granted. But where
do these goods and services come from? In this chapter we’ll see that
their production involves a decision process very similar to the one we
examined in earlier chapters. Whereas our focus in earlier chapters was
on the economic decisions that underlie the demand side of the market
relationship, our focus in this chapter is on the economic decisions that
underlie the supply side.

In this chapter we describe the production possibilities available to us

for a given state of technology and resource endowments. We want to
know how output varies with the application of productive inputs in
both the short run and the long run. Answers to these questions will set
the stage for our efforts in the next chapter to describe how firms
choose among technically feasible alternative methods of producing a
given level of output.

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There are several ways to define production. One definition,
mentioned above, is that it is any activity that creates present or
future utility.

Production may be equivalently described as a process that

transforms inputs (factors of production) into outputs. (The two
descriptions are equivalent because output is something that
creates present or future utility.)

Among the inputs into production, economists have traditionally

included land, labor, capital, and the more elusive category called
entrepreneurship. To this list, it has become increasingly common
to add such factors as knowledge or technology, organization, and
energy.

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Production function is the relationship by which inputs are combined to
produce output. Schematically, it may be represented as the box in Figure
8.1. Inputs are fed into it, and output is discharged from it. The box
implicitly embodies the existing state of technology, which has been
improving steadily over time. Thus, a given combination of productive
inputs will yield a larger number of cars with today’s technology than with
the technology of 1970.

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Yet another way of describing the production function is to cast it in the
form of a mathematical equation. Consider a production process that
employs two inputs, capital (K) and labor (L), to produce meals (Q).

The relationship between K, L, and Q may be expressed as

Q = F (K, L) (Equation 8.1)

K = Capital
L = Labor

where F is a mathematical function that summarizes the process

depicted in Figure 8.1. It is no more than a simple rule that tells how
much Q we get when we employ specific quantities of K and L.

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By way of illustration, suppose the production function for meals is given
by F(K, L) = 2KL, where K is measured in equipment-hours per week, L is
measured in person-hours per week, and output is measured in meals
per week. For example, 2 equipment-hr/wk combined with 3 person-
hr/wk would yield F(2, 3) = 12 meals/wk with this particular production
function.

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 Production Function

Production
Inputs Function Output
(L, K) q
q = f(L, K)

• Formally,
q = f(L, K)

– where q units of output are produced using L units of

labor services and K units of capital (the number of
conveyor belts).

6-7
 Production function
• Key assumptions

– given ‘state of the art’ production technology

– whatever input or input combinations are

included in a particular function, the output
resulting from their utilization is at the maximum
level

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INTERMEDIATE PRODUCTS

Capital (for example, in the form of stoves and frying pans) and
labor (for example, in the services of a chef) are clearly by
themselves insufficient to produce meals. Raw foodstuffs are also
necessary. The production process described by Equation 8.1 is
one that transforms raw foodstuffs into the finished product we
call meals. In this process, foodstuffs are intermediate products,
which many economists treat as inputs like any others. For the
sake of simplicity, we will ignore intermediate products in the
examples we discuss in this chapter.

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 Fixed and Variable Inputs
• Long run: the shortest period of time required to alter the
amounts of all inputs used in a production process.

• Short run: the longest period of time during which at least

one of the inputs used in a production process cannot be
varied.

• Variable input: an input that can be varied in the short run.

• Fixed input: an input that cannot vary in the short run.

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 Production function
• Short-run production function shows the
maximum quantity of output that can be produced
by a set of inputs, assuming the amount of at least
one of the inputs used remains unchanged

• Long-run production function shows the

maximum quantity of output that can be produced
by a set of inputs, assuming the firm is free to vary
the amount of all the inputs being used

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 Production and Utility Functions

•In Consumer Theory, consumption of GOODS lead to UTILITY:

U=f(dinner, variety meat…)

•In Production Theory, use of INPUTS causes PRODUCTION:

Q=f(Labor, Capital, Technology…)

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PRODUCTION IN THE SHORT RUN
Consider again the production process described by Q = F(K, L) = 2KL, the simple
two-input production function. And suppose we are concerned with production in
the short run—here, a period of time in which the labor input is variable but the
capital input is fixed, say, at the value K = K0 = 1. With capital held constant, output
becomes, in effect, a function of only the variable input, labor: F(K, L) = 2K0L = 2L.
This means we can plot the production function in a two-dimensional diagram, as
in Figure 8.2a. For this particular F(K, L), the short-run production function is a
straight line through the origin whose slope is 2 times the fixed value of K: Thus,
∆Q/∆L = 2K0.

A Specific Short-Run Production Function

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law of diminishing returns if other inputs are fixed, the
increase in output from an increase in the variable input must
eventually decline.
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· A technically efficient firm is attaining the maximum possible
output from its inputs (using whatever technology is appropriate)
· A technically inefficient firm is attaining less than the maximum
possible output from its inputs (using whatever technology is
appropriate)

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· production set : all points on or below the production function

Note: Capital refers to physical capital (goods that are themselves

produced goods) and not financial capital (the money required to
start or maintain production).

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Q Example: The Production Function and Technical Efficiency

Production Function
Q = f(L)
D
•
C Inefficient point
• •B
Production Set

L 17
Causes of technical inefficiency:

1) Shirking (kaçınmak)
-Workers don’t work as hard as they can
-Can be due to idleness (tembellik) or a union strategy
2) Strategic reasons for technical inefficiency
-Poor production may get government grants
-Low profits may prevent competition
3) Imperfect information on “best practices”
-inferior technology

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Example:
Acme medical equipment faces the production function:
Q=K1/2L1/2

Given labor of 10 and capital of 20, is Acme producing

efficiently by producing 12 units?
What level of production is technically efficient?

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Q =K1/2L1/2
=201/2101/2
=14.14
Acme is not operating efficiently by
producing 12 units. Given labour of 10
and capital of 20, Acme should be
producing 14.14 units in order to be
technically efficient.

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 Short-Run Production
• In the short run, the firm’s production
function is
q = f(L, K)

– where q is output, L is workers, and K is the fixed

number of units of capital.
 Production in the Short Run
• Three properties:
[Link] passes through the origin
[Link] the addition of variable inputs augments
output an increasing rate
[Link] some point additional units of the
variable input give rise to smaller and smaller
increments in output.

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An Important Characteristic of Short-
Run Production Functions

• Law of diminishing returns: if other inputs

are fixed, the increase in output from an
increase in the variable input must
eventually decline.

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 LAW OF DIMINISHING MARGINAL RETURNS

• As the quantity of a variable input (labor, in the example)

increases while all other inputs are fixed, output rises. Initially,
output will rise more and more rapidly, but eventually it will
slow down and perhaps even decline.
• This is called the LAW OF DIMINISHING MARGINAL RETURNS
 Law of Diminishing
Returns
INCREASES IN ONE FACTOR OF PRODUCTION,
HOLDING ONE OR OTHER FACTORS FIXED,
AFTER SOME POINT,
MARGINAL PRODUCT DIMINISHES.
MP

A SHORT
point of
RUN LAW
diminishing
returns
Variable input
 Law of Diminishing MP

• For example: Consider a factory with 10 jean machines.

Suppose one machine can be used by one worker. The first
ten workers can each have a machine. The next few can carry
raw materials for those on the machines. However eventually
you get to a point where additional workers are just standing
around getting in each others way. Eventually the MP of each
additional hour worked will decline due to the bottleneck in
the number of machines.
• The law of diminishing MP is the reason why TP, AP and MP
curves rise reach a max and then fall.
 Short-Run Production Function
Components
• Total product curve: shows the amount of output
as a function of the amount of variable input.

• Marginal product: change in total product due to a

1-unit change in the variable input.
MPL = ΔQ/ΔL

• Average product (Labor productivity): total output

divided by the quantity of the variable input.
APL =Q/L
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TP, AP & MP Numerical Example

Quantity of Total Average Marginal

Labor Product Product Product
0 0
1 15 15 15
2 34 17 19
3 48 16 14
4 60 15 12
5 62 12.4 2
 Production with One
Variable Input (Labor) - SR
TABLE 6.1 PRODUCTION WITH ONE VARIABLE INPUT
AMOUNT OF AMOUNT OF TOTAL OUTPUT AVERAGE
MARGINAL PRODUCT
LABOR (L) CAPITAL (K) (q) PRODUCT
0 10 0 — —

1 10 10 10 10

2 10 30 15 20

3 10 60 20 30

4 10 80 20 20

5 10 95 19 15

6 10 108 18 13

7 10 112 16 4

8 10 112 14 0

9 10 108 12 -4

10 10 100 10 -8
Q Example: Production as workers increase
Each Each
Each Additional Additional
Additional worker worker
worker Is less Decreases
Is equally productive Production
productive

Each
Additional
worker
Is more
Total Product
productive

L 30
Figure 8.6: Total, Marginal, and
Average Product Curves

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The Slopes of the Production Curve

PRODUCTION WITH
ONE VARIABLE INPUT
The total product curve in (a) shows
the output produced for different
amounts of labor input.
The average and marginal products in
(b) can be obtained (using the data in
Table 6.1) from the total product curve.
At point A in (a), the marginal product
is 20 because the tangent to the total
product curve has a slope of 20.
At point B in (a) the average product
of labor is 20, which is the slope of the
line from the origin to B. 20

The average product of labor at point

C in (a) is given by the slope of the
line 0C.
The Slopes of the Product Curve

PRODUCTION WITH
ONE VARIABLE INPUT
To the left of point E in (b), the
marginal product is above the average
product and the average is increasing;
to the right of E, the marginal product
is below the average product and the
average is decreasing.
As a result, E represents the point at
which the average and marginal
products are equal, when the average
product reaches its maximum.
At D, when total output is maximized,
the slope of the tangent to the total
20
product curve is 0, as is the marginal
product.
Relationships Among Total, Marginal and
Average Product Curves
• When the marginal product curve lies above the
average product curve, the average product curve
must be rising

• When the marginal product curve lies below the

average product curve, the average product curve
must be falling.

• The two curves intersect at the maximum value of

the average product curve.
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 TP, AP & MP Graphical Example
Points to Note:
• When AP is rising it is always less than MP and
when it is falling it is always greater than MP. MP
= AP when AP is at its max.

• MP = 0 when TP reaches its max and AP = 0 when

TP = 0
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 Short Run Production Function
Numerical Example

Marginal Product
L Q MP AP
0 0 --- --- Average
1 20 20 20 Product
2 46 26 23
3 70 24 23.33
4 92 22 23
5 110 18 22

L
1 2 3 4 5
 Production In The Long Run
• In the long run, by contrast, all factors of
production are by definition variable.
• To illustrate, consider again the production function
Q=F(K,L)=2KL
• Suppose we want to describe all possible
combinations of K and L that give rise to a
particular level of output—say, Q = 16
• To do this, we solve Q = 2KL = 16 for K in terms of L
K=8/L

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 Production Isoquants
• In the long run, all inputs are variable &
isoquants are used to study production
decisions
– An isoquant is a curve showing all possible input
combinations capable of producing a given level of
output
– Isoquants are downward sloping; if greater
amounts of labor are used, less capital is required
to produce a given output
Isoquant: the set of all input combinations that yield a
given level of output.

Equation for an Isoquant:

q = f (L, K)

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PRODUCTION WITH TWO
VARIABLE INPUTS
A set of isoquants, or isoquant
map, describes the firm’s
production function.
Output increases as we move
from isoquant q1 (at which 55
units per year are produced at
points such as A and D),
to isoquant q2 (75 units per year
at points such as B), and
to isoquant q3 (90 units per year
at points such as C and E).

By drawing a horizontal line at a particular level of capital—say 3, we can observe

diminishing marginal returns. Reading the levels of output from each isoquant as
labor is increased, we note that each additional unit of labor generates less and less
additional output.
A Typical Isoquant Map
Figure 8.7: Part of an Isoquant Map for the
Production Function

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 Properties of Isoquants
1. Cardinal—each isoquant represents a certain Q whose
value is objective.
2. Coverage—for any point, there is always an isoquant
passing through it
3. Negative Slope—because MPL>0, MPK>0 (assuming
not in Region III)
4. Can’t cross
5. Bending towards the origin
6. Farther away from the origin, the greater the quantity.
 Figure 8.8: The Marginal Rate
of Technical Substitution
Marginal rate of technical substitution (MRTS):
the rate at which one input can be exchanged for
another without altering the total level of output.

MPK ΔK = MPL ΔL

ΔK/ΔL = MPL/MPK

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Marginal Rate of Technical Substitution
• The MRTS is the slope of an isoquant &
measures the rate at which the two inputs can
be substituted for one another while
maintaining a constant level of output

K
MRTS 
L
Marginal Rate of Technical Substitution
• The MRTS can also be expressed as the ratio
of two marginal products:
MPL
MRTS 
MPK
As labor is substituted for capital, MPL declines & MPK
rises causing MRTS to diminish

K MPL
MRTS  
L MPK
 Isoquants and Slopes
Q  f ( K , L)
( K , L )  ( K  K , L  L )
f ( K , L) f ( K , L)
Q 
 K  L
K L
 MPK K  MPL L
Supp. Q 0 (  we are moving along an isoquant).
K MPL
Slope of Isoquant   , -ve
L MPK
dK MPL
MRTS   , the maximum amount of K
dL Q Q MPK
a producer would willingly forgo for one more unit of L,
holding output level constant.
Output Elasticities
f f
dQ  dL  dK
L K
dQ f dL  L  f dK  K 
    
Q L Q  L  K Q  K 
f L dL f K dK
 
L Q L K Q K
 dL   dK 
EQ; L    EQ; K  
 L   K 
MPL MPK
where EQ; L  , EQ; K 
APL APK
 Output Elasticities
dL dK d 
Suppose   , same proportional change in inputs.
L K 

dQ / Q % change in output
R 
d  /  % change in all input
1 i.r.t.s.
1 c.r.t.s.
1 d.r.t.s.

MPL MPK
R  EQ ,L  EQ ,K  
APL APK
An Example: Cobb-Douglas Production
Function
1 1
Q  f ( K , L) 10 K L
2 2

1
1 1
Q  1 1 K 2
MPL  10 K   L
2 2
5  
L  2  L
1
1 1
Q  1 1  L 2
MPK  10   K 2
L 5  
2
K  2 K
1
MPL 5 K / L  K 2
MRTS   1

MPK 5 L / K 2 L
 
An Example: Cobb-Douglas Production
Function
1 1 1
Q 10 K L 2
K
2 2
APL   10  
L L  L
1
Q  L 2
APK  10  
K K
1
MPL 5 K / L  21
 EQ ;L   
APL 10 K / L 12 2
 
1
MPK 5 L / K  2 1
EQ ;K   1

APK 10 L / K 2 2
 
Cobb-Douglas production function

Q  f ( K , L) 10 K  L
Q Q
MPL  10 K  L 10 K L  L  
 1   1

L L
Q 1  Q
MPK  10 K L 
K K
MP Q / L  K
MRTS  L  
MPK Q / K  L
MPL  Q / L
EQ ;L   
APL Q/L
EQ ;K  and R   
Special LR Production Functions
1. Perfect Substitutes: ( q =f(L,K)= AL + BK ), where A and B are
positive constants.
 Linear Production Function

Q bL
Q aK  bL or K  
a a
K MPL b
MRTS  
MPK a

b
Slope= 
a
Q0
a

L
Q0
b
ISOQUANTS WHEN INPUTS
ARE PERFECT SUBSTITUTES
When the isoquants are straight
lines, the MRTS is constant.
Thus the rate at which capital
and labor can be substituted for
each other is the same no
matter what level of inputs is
being used.
Points A, B, and C represent
three different capital-labor
combinations that generate the
same output q3.
Special LR Production Functions
2. Fixed-proportion: q = =f(L,K)= min{aL, bK} , where a and b
are positive constants
 Leontief Production Function
Q min aK , bL
e.g. Q min 2 K , L
K
2K=L

(or aK=bL, in general)

L
2
FIXED-PROPORTIONS
PRODUCTION FUNCTION
When the isoquants are L-
shaped, only one combination
of labor and capital can be
used to produce a given output
(as at point A on isoquant q1,
point B on isoquant q2, and
point C on isoquant q3). Adding
more labor alone does not
increase output, nor does
adding more capital alone.
Special LR Production Functions
3. Cobb-Douglas: q =f(L,K)= A La Kb , where A, a and b are
positive constants.
 Marginal Productivities (MP)
• The marginal product of an input is the change
in output that results from a small change in
an input holding the levels of other inputs
constant.

q f (L,K)
MPL  = (holding capital level constant)
L L
q f (L,K)
MPK  = (holding labor level constant)
K K


 Returns To Scale
• Increasing returns to scale: the property of a production
process whereby a proportional increase in every input
yields a more than proportional increase in output.

• Constant returns to scale: the property of a production

process whereby a proportional increase in every input
yields an equal proportional increase in output.

• Decreasing returns to scale: the property of a production

process whereby a proportional increase in every input
yields a less than proportional increase in output.

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 Returns to Scale
• Returns to scale helps us to understand how output
will respond to the increases in all inputs together
– Suppose that all inputs are doubled, would the output
double?
• There are three types of returns to scales: for t>1
• Increasing Returns to Scale (IRS): f (tL,tK)  tf (L,K)

• Constant Returns to Scale (CRS): f (tL,tK) tf (L,K)

• Decreasing Returns to Scale
(DRS): f (tL,tK)  tf (L,K)


RETURNS TO SCALE

When a firm’s production process exhibits However, when there are increasing
constant returns to scale as shown by a returns to scale as shown in (b), the
movement along line 0A in part (a), the isoquants move closer together as
isoquants are equally spaced as output inputs are increased along the line.
increases proportionally.
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Production Function & Utility Function

Production Function Utility Function

Output from inputs Preference level from
consumption
Isoquant Curve Indifference Curve
Marginal Rate of Technical Marginal Rate of Substitution
Substitution (MRTS) (MRS)
Marginal Productivities Marginal Utilities
 Cobb-Douglas Function
We have the Cobb - Douglas Production Function
Y K  L
Increase the inputs by a factor s
Y1 δ sK  sL  s α  β δK α Lβ s α  βY
α β

Our Cobb - Douglas function is homogeneous of degree    .

If     1, we have decreasing returns to scale.
If    1, we have constant returns to scale.
If     1, we have increasing returns to scale.
 Euler’s Theorem
• Homogeneity of degree 1 is often called linear
homogeneity.
• An important property of homogeneous
functions is given by Euler’s Theorem.
 Euler’s Theorem

For any multivaria te function y  f(x1,x2 , ,xn )

that is homogeneous of degree k ,
ky  x1 f1(x1,x2 , ,xn )    xn f n(x1,x2 , ,xn )
for any set of values (x1,x2 , ,xn ), where f i(x1,x2 , ,xn )
is the partial derivative of the function w ith respect to
its ith argument.
 Division of National Income
Suppose that the national production function is
Y K  L1  which is homogeneous of degree 1, therefore
Y Y
Y K L
K L
Now under perfect competitio n, capital and labor are paid
respective ly their real return and real wage. This implies
Y
 
wL  L  1   K  L  L 1   Y
L
Y
and rK 
K
 
K  K   1 L1  K Y .

Hence, Y rK  wL Y  1   Y